Harnessing Volatility with Bollinger BandsTHE CMC MarkETs Trading sMarT sEriEs
CMC Markets | Harnessing Volatility with Bollinger Bands 2
As a trader, you need to have a good understanding of the nature of market volatility and the way it impacts your positions. One of the most popular – and one of the most reliable – tools that traders have at their disposal is Bollinger Bands, developed in the 1980s and named after its creator, John Bollinger.
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CMC Markets | Harnessing Volatility with Bollinger Bands 3
What are Bollinger Bands?When it comes to watching price movements of any instrument that
you’re trading, it is very useful to have an understanding of where
price is trading relative to its average.
The moving average is a popular way of doing this, because it
demonstrates the average value of the instrument over recent
trading conditions. When you see the price above the moving
average you may think it’s bullish, and when it is below you may think
it’s bearish. What do you feel, however, if the price is a long way
above or below the moving average? And is it too far above or below
the moving average for you to still feel bullish or bearish? Maybe now
you want to be a contrarian!
Bollinger Bands add a further assessment of recent trading activity
by using a very powerful statistical measurement tool: the standard deviation. In essence, the standard deviation provides a value within
which the price has a probability of not moving further. A simpler way
to say this is that if the price moves outside the envelope formed by
the standard deviations, then it is quite a significant event. We will
look at this in more depth, but for now the key thing is recognising
that the envelope formed by the Bollinger Bands can be quite useful
in gaining an appreciation of how far price has moved away from its
average – and what you can do about it.
Before going any further, however, we need to look a little more at
standard deviation to help you gain an appreciation of what that
means to you as a follower of Bollinger Bands.
Harnessing Volatility with Bollinger Bands
Understand one of the key tools for any trader. Find out how to put one of the methods described by John Bollinger into practice. Gain an understanding of the limitations of Bolliner Bands, and what it really represents.
In chart 1, you can see a distribution, or bell, curve. This tells you
that based on the number of observations that have been taken
(for example, index prices over the last 20 days), 95% will occur
within +/–2 standard deviations of the moving average.
-4.0 -2.0 0.0 2.0 4.0
68 95 99
CHART 1 Two standard deviations covers 95% of expected distribution.
CMC Markets | Harnessing Volatility with Bollinger Bands 4
What does this distribution curve mean to you? It is of real
importance, because the Bollinger Bands are placed at a distance
of +2 and –2 standard deviations away from the moving average.
So if you don’t have any idea what the relevance of the standard
deviation is, you are not going to know what the Bollinger Bands
are telling you. The main thing to think about at this point is that
the envelope of the bands should contain the vast majority of
trading activity. Therefore, a move outside of these bands is, in
fact, a statistically very significant event. In this guide we want to
consider what you need to do when this occurs.
There are a large number of different ways in which traders interpret
this information. We examine one that was espoused by John
Bollinger himself.
You may also think that putting a fixed percentage amount as an
envelope above and below the price may be an effective way of
containing the majority of price movement. This may be the case,
but it lacks a crucial advantage of the Bollinger Bands: the fact that
The Bollinger Bands are represented by the three lines around the
price movements. The middle line is the 20-period moving average.
This is the default value of this component of the indicator. The
upper line is the value of the moving average plus two standard
deviations, while the lower line is the moving average minus two
standard deviations. You can see how these upper and lower bands
because the bands are based on standard deviations, they will widen
and narrow around the moving average depending on the recent
level of volatility that the price has demonstrated. This means that
the lower the level of recent price volatility, the narrower the bands
will be. The greater the recent volatility has been, the greater the
width of the range contained by the bands. Merely by looking at
the bands it is possible to get a very good idea of what the recent
trading conditions have been like for the instrument that you are
considering.
How Bollinger Bands apply to your trading
Now that we’ve looked at the composite parts of the standard
deviation, it’s time to take a look at the Bollinger Bands themselves
and how they apply to your trading.
A typical chart with the Bollinger Bands in place might look
something like chart 2:
envelope the price for the majority of the time. For traders who
use Bollinger Bands, the time of greatest interest is when the price
moves outside of the bands, because this is what would be referred
to as a statistically significant event. It is important to be able to
respond accordingly to the setups you are provided with.
CHART 2 Bollinger Bands adapt to changing market conditions.
CMC Markets | Harnessing Volatility with Bollinger Bands 5
CHART 3 Price movements outside the bands are statistically significant.
Chart 3 is simply a closer look at one of the components contained
in chart 2. You can see that when price starts to move very quickly
it moves outside the boundaries of the bands. What also adjusts
quickly is the direction and the width of the bands.
In general terms, when the instrument becomes more volatile the
bands move further apart. This is because the standard deviation
value increases. When the price moves in one direction consistently,
the moving average will gradually change direction to follow it. It is
for these reasons that the price generally will not stay outside of the
Bollinger Bands for very long: they adapt to keep price trading within
them.
The W formation
In this guide we are primarily examining a single methodology to
apply using the Bollinger Bands. However, to better illustrate its use
it is important to describe at least the groundings of another method
which can be employed at the breakout of the Bollinger Bands. One
of the books on the general topic, Technical Analysis by Kirkpatrick
and Dahlquist, leads the authors’ discussion with the following:
In line with the basic concept of following the trend, bands and envelopes are
used to signal when a trend change has occurred and to reduce the number
of whipsaws that occur within a tight trading range. While looking at the
envelopes or bands on a chart, one would think that the best use of them
might be to trade within them from the high extreme to the low extreme
and back. Similar to strategies for rectangle patterns, however, the trading
between bands is difficult. First, by definition, except for fixed envelopes
the bands contract during a sideways, dull trend and leave little room for
manoeuvring at a cost-effective manner and with profitable results. Second,
when prices suddenly move on a new trend, they will tend to remain close to
the band in the direction of the trend and give many false exit signals. Third,
when the bands expand, they show that volatility has increased, usually due
to the beginning of a new trend, and any position entered in anticipation of
low volatility is quickly stopped out.
What you can take away from this is that you shouldn’t try to use
Bollinger Bands in the same way as you might use some other type
of indicators that tell you an instrument may be overbought or
oversold. Instead, these bands show you when a new trend may be
developing, so you should generally resist the temptation of trading
against the direction of the initial breakout of the price through
either the upper or the lower bands. Some traders will look to this
breakout-type trade as a means of going long or short if the price
closes above the upper band, or short if it closes below the lower
band. The trade remains in place until the price closes on the far
side of the moving average line that runs between the two standard
deviation lines.
The main trading method that we want to discuss using Bollinger
Bands is one described by John Bollinger himself in his 2002 book,
Bollinger on Bollinger Bands. What you are looking for in this setup is
called a W formation. Bollinger describes several different variations
of the W formation in his book, but we will be looking at it in general
terms. The name of this setup provides a good idea as to the shape
of the price pattern that you are looking for: a W. The thing that you
need to put more thought into, however, is how this pattern then
interacts with Bollinger Bands.
CMC Markets | Harnessing Volatility with Bollinger Bands 6
CHART 4 The beginnings of a trade setup.
As with many setups, the W is one that can be used for trading on
either the long side or the short side. All the examples below can be
reversed and traded in the opposite direction where the initial setup
is the opposite, depending on whether you start with an uptrend or
a downtrend.
For our first example, we will start without the Bollinger Bands so
you can see the basic setup pattern to look for, in this case a strong
trending movement either upwards or downwards. In chart 4, you are
looking at a downtrend.
The point where the arrow is drawing your attention in chart 5 is the
first low. The key takeout from this is that the low point of this first
trend trough in the W formation is outside the Bollinger Bands (it is
also acceptable for the price to just touch the band). As discussed
earlier, this is quite a significant event considering how much of the
price action you would expect the two-standard-deviation envelope
to contain. You can see that the second trough is inside the bands.
The circled component of chart 4 highlights the W. This is where the
trend has bottomed and then retested after a short reversal, which
forms the pattern we’re interested in. The right hand low
can be higher than, equal to, or lower than the previous low. In
the next chart we take a look at the same setup, but add in the
Bollinger Bands because this enables us to measure how extreme
a movement we are viewing.
The Bollinger Bands are telling us that while the first trough has
a statistically high variance from the moving average, the second
trough – being inside the bands – does not. To a trader looking only
at price, the market still looks weak. However, a trader using Bollinger
Bands is being given a clue that the trend is losing momentum.
Changes in momentum often precede changes in trend and, used
judiciously, can be a useful tool for traders looking to get set early
in the life of a trend.
CHART 5 Overlay the pattern onto the Bollinger Bands.
CMC Markets | Harnessing Volatility with Bollinger Bands 7
Buy
Second trough in the W. Note that the candle low is inside the lower Bollinger Band and surrounded by two higher lows.
CHART 6 The formation of the second trough is the key signal.
Once the pattern forms the second trough, as in chart 6, you will look
to make an entry into the trade. The way to know that a trough has
been formed is when the instrument being traded closes above the
Chart 7 presents an example of a trade that would trigger as a short
position. In this case you are looking for an M formation. It pays not
to be too precise in looking for a perfect M. The two peaks can be
quite lopsided, with the second one quite a bit higher or lower than
the first. The key thing is that the price on the first peak has moved
highest point of the candle that made the lowest low (that is, the
lowest point of the trough). You should wait until it has closed at this
level so that you have confirmation of this W formation.
outside of the Bollinger Bands and the second has remained within
them. This demonstrates weakening deviation from the mean, even
where the second peak is quite a bit higher than the first.
This is a very useful trade setup for a wide range of different
markets and timeframes.
CHART 7 The same pattern reversed can give a good short trade.
CMC Markets | Harnessing Volatility with Bollinger Bands 8
1st stop2nd stop
3rd stop
4th stop
Final stop
CHART 8 Place your stop at the first point you know a reversal has occurred.
In the case of chart 8 your first stop could be placed above the high
point of the second peak in the M. The rationale for this should be
quite easy to see: if the price reaches this level the pattern is no
longer valid, so you have no reason to remain in the trade. Some
traders will allow some tolerance above the peak to reduce the risk
of being stopped out on a false break of the resistance. You will
want to trail the stop lower as the trade continues to move in your
favour so as to take the opportunity to lock any potential profits. You
can see on the chart that one way of doing this would be to place
the stop above each new corrective peak in the downtrend as it is
subsequently formed.
Review • Youshouldunderstandwhatstandarddeviationmeans
andhowtoapplyitaspartoftheBollingerBands.
• Youshouldbeabletosearchfortradesetupsandbeable
todeterminewhicharesuitableandwhicharenot.
• Youshouldbeabletoeffectivelymanageyourriskthrough
applyingasensiblestoplossstrategy.
Bollinger Bands and stop loss
As with any trade you make, you should have a very clear picture of
where you place your stop loss. As something of a side note, you
will likely find all of your trading becomes much more relaxing when
you take on a sensible stop loss strategy, because you have then
quantified your risk. Trading can be stressful for traders who have
no plan as to when they will exit a losing trade. Sensible traders will
know up front where they will place their stop and how much they
will have at risk before they even enter the trade rather than trying
to make their strategy up on the fly.
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